Ackman Sees Big Upside to Fannie, Freddie Bet

William Ackman is taking a big gamble on Fannie Mae and Freddie Mac but recently said at an investment conference he sees a huge upside on the bet: the hedge-fund manager said he believes the common shares of the mortgage-finance giants could be worth more than 10 times their current value in several years.

In his first extended comments since he bought sizable stakes in Fannie and Freddie, Mr. Ackman said he is convinced shareholders will win their lawsuits against the U.S. government that challenged the Treasury Department’s bailout agreement with the two companies, according to people who heard Mr. Ackman’s remarks.

Mr. Ackman predicted the Supreme Court would side with the plaintiffs if the suit reaches the court. He said the common shares upon a legal victory would then be worth about 10 to 15 times their current value, according to the people who were there.

Mr. Ackman also said that despite various legislative proposals in Congress that would create new mortgage guarantors, he believed Fannie and Freddie would escape liquidation and instead be revamped, perhaps with increased capital requirements and other protections.

Mr. Ackman made his comments at the annual meeting of Entrust Capital, a New York firm that invests billions of client money in hedge funds. The event was closed to the press.

His remarks place him in a camp with other big shareholders that are bullish on Fannie and Freddie. But the others, including Bruce Berkowitz of Fairholme Capital Management LLC and Richard Perry of Perry Capital LLC, hold preferred shares. Perry and Fairholme are among the firms that sued the U.S. Treasury last year challenging the government’s bailout terms.

Mr. Ackman’s Pershing Square Capital Management LP bought nearly 10% of the firms’ common shares. Those are seen by some as riskier investments because the U.S. government has warrants that it hasn’t yet exercised to acquire nearly 80% of those shares, a move that would dilute current investors. In filings last November, Pershing Square said it had spent about $400 million on its investments.

Mr. Ackman’s bet on the common shares reflects his conviction that they have more upside than the preferred shares if the companies are ultimately restored as privately owned entities, according to a person familiar with Pershing Square’s thinking.

The bet is also in some ways a bluff that Congress and the White House will follow through on pledges to liquidate Fannie and Freddie. If the government does liquidate the firms without exercising the warrants, it would be foregoing a major windfall. The only scenario in which stockholders would make money is one where taxpayers see that windfall.

On Friday, Fannie reported an $84 billion annual profit for 2013, and said it would pay $7.2 billion in dividends to the Treasury next month. That means it will join Freddie Mac in having paid dividends that exceed the Treasury’s investments in the firms between 2008 and 2011.

Fannie and Freddie aren’t listed on a major U.S. exchange, following a 2010 delisting, and their common shares have mostly traded at about $1 to $2 each since the government rescued the firms. On Friday, Fannie shares fell 0.3%, or 1 cent, to $3.28, and Freddie added 2 cents, or 0.6%, to $3.24.

Fannie and Freddie don’t make loans but instead buy them from lenders who package them into securities. They have built deep and liquid markets for those bonds, and those markets, in turn, provide the primary way Americans are able to access the popular 30-year, fixed-rate mortgage, which isn’t widely available in other countries.

When the U.S. took over Fannie and Freddie in 2008 through a legal process known as conservatorship, it agreed to inject nearly unlimited sums of aid—ultimately around $187.5 billion—and received in exchange a new class of “senior preferred” shares that initially paid a 10% dividend, along with the warrants for the common stock.

Because the common and preferred stock wasn’t ever wiped out, investors continued to trade them. Some concluded—accurately, it turned out—that Fannie and Freddie had reserved more money for loan losses than they would need, and that they would one day return to profitability.

The Treasury revamped the bailout terms in August 2012, eliminating the 10% dividend and requiring all of their profits instead. A dividend is no longer required in periods when the firms report losses. The changes prevent the companies from retaining most of their earnings, and dividend payments can’t be counted towards paying down the government’s investment.

Investors have argued that the changes ran afoul of the law that gave the U.S. the power to put Fannie and Freddie into conservatorship, and that they amounted to illegal self-dealing between the Treasury and the firms’ regulator, which is tasked with overseeing the companies during the conservatorship.